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Finance
Course:
Investment s and Portfolio

Volume 1

Instructor:
Tatyana Zabotina
University of Illinois at Springfield

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McGraw-Hill/Irwin

McGraw−Hill Primis
ISBN: 0−390−48886−0
Text:
Investments, Sixth Edition
Bodie−Kane−Marcus


This book was printed on recycled paper.
Finance

/>Copyright ©2003 by The McGraw−Hill Companies, Inc. All rights
reserved. Printed in the United States of America. Except as
permitted under the United States Copyright Act of 1976, no part
of this publication may be reproduced or distributed in any form
or by any means, or stored in a database or retrieval system,
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This McGraw−Hill Primis text may include materials submitted to

McGraw−Hill for publication by the instructor of this course. The
instructor is solely responsible for the editorial content of such
materials.

111

FINA

ISBN: 0−390−48886−0


Finance

Volume 1
Bodie−Kane−Marcus • Investments, Sixth Edition
Front Matter

1

Preface

1

I. Introduction

14

2. Financial Instruments
1. The Investment Environment
3. How Securities are Traded

4. Mutual Funds and Other Investment Companies

14
48
76
118

II. Portfolio Theory

146

5. History of Interest Rates and Risk Premiums
6. Risk and Risk Aversion
7. Capital Allocation Between the Risky Asset and the Risk−Free Asset
8. Optimal Risky Portfolios

146

III. Equilibrium in Capital Markets

286

9. The Capital Asset Pricing Model
10. Index Models
11. Arbitrage Pricing Theory and Multifactor Models of Risk and Return
12. Market Efficiency and Behavioral Finance
13. Empirical Evidence on Security Returns

286
322

348
374

174
206
231

420

IV. Fixed−Income Securities

450

14. Bond Prices and Yields
15. The Term Structure of Interest Rates
16. Managing Bond Portfolios

450
490
521

V. Security Analysis

571

17. Macroeconomic and Industry Analysis
18. Equity Valuation Models
19. Financial Statement Analysis

571

604
653

VI. Options, Futures, and Other Derivatives

693

20. Options Markets: Introduction
21. Option Valuation
22. Futures Markets
23. Futures and Swaps: A Closer Look

693
741
786
815

iii


VII. Active Portfolio Management

853

24. Portfolio Performance Evaluation
25. International Diversification

853
896

iv


Bodie−Kane−Marcus:
Investments, Sixth Edition

Front Matter

Preface

© The McGraw−Hill
Companies, 2004

P R E F A C E

xviii

We wrote the first edition of this textbook more than 15 years ago. The intervening years
have been a period of rapid and profound change in the investments industry. This is due in
part to an abundance of newly designed securities, in part to the creation of new trading
strategies that would have been impossible without concurrent advances in computer technology, and in part to rapid advances in the theory of investments that have come out of the
academic community. In no other field, perhaps, is the transmission of theory to real-world
practice as rapid as is now commonplace in the financial industry. These developments
place new burdens on practitioners and teachers of investments far beyond what was required only a short while ago.
Investments, Sixth Edition, is intended primarily as a textbook for courses in investment
analysis. Our guiding principle has been to present the material in a framework that is organized by a central core of consistent fundamental principles. We make every attempt to
strip away unnecessary mathematical and technical detail, and we have concentrated on
providing the intuition that may guide students and practitioners as they confront new ideas
and challenges in their professional lives.
This text will introduce you to major issues currently of concern to all investors. It can

give you the skills to conduct a sophisticated assessment of current issues and debates covered by both the popular media as well as more-specialized finance journals. Whether you
plan to become an investment professional, or simply a sophisticated individual investor,
you will find these skills essential.
Our primary goal is to present material of practical value, but all three of us are active
researchers in the science of financial economics and find virtually all of the material in
this book to be of great intellectual interest. Fortunately, we think, there is no contradiction
in the field of investments between the pursuit of truth and the pursuit of money. Quite the
opposite. The capital asset pricing model, the arbitrage pricing model, the efficient markets
hypothesis, the option-pricing model, and the other centerpieces of modern financial research are as much intellectually satisfying subjects of scientific inquiry as they are of immense practical importance for the sophisticated investor.
In our effort to link theory to practice, we also have attempted to make our approach
consistent with that of the Institute of Chartered Financial Analysts (ICFA), a subsidiary of
the Association of Investment Management and Research (AIMR). In addition to fostering
research in finance, the AIMR and ICFA administer an education and certification program
to candidates seeking the title of Chartered Financial Analyst (CFA). The CFA curriculum
represents the consensus of a committee of distinguished scholars and practitioners regarding the core of knowledge required by the investment professional. This text also is
used by the CAIA Association, a nonprofit association that provides education concerning
nontraditional investment vehicles and sponsors the Chartered Alternative Investment
Analyst designation.
There are many features of this text that make it consistent with and relevant to the CFA
curriculum. The end-of-chapter problem sets contain questions from past CFA exams, and,
for students who will be taking the exam, Appendix B is a useful tool that lists each CFA
question in the text and the exam from which it has been taken. Chapter 3 includes excerpts
from the “Code of Ethics and Standards of Professional Conduct” of the ICFA. Chapter 26,
which discusses investors and the investment process, is modeled after the ICFA outline.
In the Sixth Edition, we have further extended our systematic collection of Excel
spreadsheets that give tools to explore concepts more deeply than was previously possible.

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Bodie−Kane−Marcus:
Investments, Sixth Edition

Front Matter

Preface

© The McGraw−Hill
Companies, 2004

PREFACE

xix

These spreadsheets are available on the website for this text (www.mhhe.com/bkm), and
provide a taste of the sophisticated analytic tools available to professional investors.

UNDERLYING PHILOSOPHY
Of necessity, our text has evolved along with the financial markets. In the Sixth Edition, we
address many of the changes in the investment environment.
At the same time, many basic principles remain important. We believe that attention to
these few important principles can simplify the study of otherwise difficult material and
that fundamental principles should organize and motivate all study. These principles are
crucial to understanding the securities already traded in financial markets and in understanding new securities that will be introduced in the future. For this reason, we have made
this book thematic, meaning we never offer rules of thumb without reference to the central
tenets of the modern approach to finance.
The common theme unifying this book is that security markets are nearly efficient,
meaning most securities are usually priced appropriately given their risk and return attributes. There are few free lunches found in markets as competitive as the financial market.

This simple observation is, nevertheless, remarkably powerful in its implications for the
design of investment strategies; as a result, our discussions of strategy are always guided
by the implications of the efficient markets hypothesis. While the degree of market efficiency is, and always will be, a matter of debate, we hope our discussions throughout the
book convey a good dose of healthy criticism concerning much conventional wisdom.

Distinctive Themes Investments is organized around several important themes:
1. The central theme is the near-informational-efficiency of well-developed security
markets, such as those in the United States, and the general awareness that
competitive markets do not offer “free lunches” to participants.
A second theme is the risk–return trade-off. This too is a no-free-lunch notion,
holding that in competitive security markets, higher expected returns come only
at a price: the need to bear greater investment risk. However, this notion leaves
several questions unanswered. How should one measure the risk of an asset? What
should be the quantitative trade-off between risk (properly measured) and expected
return? The approach we present to these issues is known as modern portfolio
theory, which is another organizing principle of this book. Modern portfolio theory
focuses on the techniques and implications of efficient diversification, and we
devote considerable attention to the effect of diversification on portfolio risk as
well as the implications of efficient diversification for the proper measurement
of risk and the risk–return relationship.
2. This text places greater emphasis on asset allocation than most of its competitors.
We prefer this emphasis for two important reasons. First, it corresponds to the
procedure that most individuals actually follow. Typically, you start with all of your
money in a bank account, only then considering how much to invest in something
riskier that might offer a higher expected return. The logical step at this point is
to consider other risky asset classes, such as stock, bonds, or real estate. This is an
asset allocation decision. Second, in most cases, the asset allocation choice is far
more important in determining overall investment performance than is the set of
security selection decisions. Asset allocation is the primary determinant of the
risk-return profile of the investment portfolio, and so it deserves primary

attention in a study of investment policy.


Bodie−Kane−Marcus:
Investments, Sixth Edition

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Front Matter

Preface

© The McGraw−Hill
Companies, 2004

PREFACE

3. This text offers a much broader and deeper treatment of futures, options, and
other derivative security markets than most investments texts. These markets have
become both crucial and integral to the financial universe and are the major sources
of innovation in that universe. Your only choice is to become conversant in these
markets—whether you are to be a finance professional or simply a sophisticated
individual investor.

NEW IN THE SIXTH EDITION
Following is a summary of the content changes in the Sixth Edition:

The Investment Chapter 1 contains extensive new material on failures in corporate goverEnvironment nance in the boom years of the 1990s and the conflicts of interest that gave
(Chapter 1) rise to the many scandals of those years.
How Securities We have added new material on securities trading including initial public

Are Traded (Chapter 3) offerings, electronic trading, and regulatory reforms in the wake of recent
corporate scandals to Chapter 3.

History of Interest We have extended the historical evidence on security returns to include
Rates and Risk international comparisons as well as new approaches to estimating the mean
Premiums (Chapter 5) market return. We also have added an introduction to value at risk using
historic returns as a guideline.

Arbitrage Pricing
Theory and Multifactor
Models of Risk and
Return (Chapter 11)

We have largely rewritten this chapter. There is now greater focus on the use
of factor models as a means to understand and measure various risk exposures. The intuition for the multifactor risk–return relation has been enhanced, and the comparison between the multifactor APT and CAPM has
been further developed.

Market Efficiency and We have fully reworked our treatment of behavioral finance by adding more
Behavioral Finance careful development of behavioral hypotheses, their implications for secu(Chapter 12) rity pricing, and their relation to the empirical evidence on security pricing.
Empirical Evidence on We have updated our discussion of the value and size effects, with an emSecurity Returns phasis on competing interpretations of these premiums.
(Chapter 13)
Bond Prices and Yields We have added new spreadsheet material helpful in analyzing bond prices
(Chapter 14) and yields. This new material enables students to price bonds between
coupon dates.

Equity Valuation We have added new material on quality of earnings, earnings management,
Models (Chapter 18) and the use of accounting data in valuation analysis to this chapter.

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Investments, Sixth Edition

Front Matter

Preface

© The McGraw−Hill
Companies, 2004

xxi

PREFACE

Financial Statement We have added new material related to the accounting scandals of the last
Analysis (Chapter 19) few years to this chapter. It discusses ways in which accounting rules were
skirted in the 1990s and ongoing reforms in accounting standards.

Option Valuation We have extended the binomial option pricing model to a multiperiod exam(Chapter 21) ple to illustrate how the model may be used to obtain realistic prices.
International We have fully rewritten this chapter, which now contains considerably more
Diversification evidence on global financial markets and security returns.
(Chapter 25)
In addition to these changes, we have updated and edited our treatment of
topics wherever it was possible to improve exposition or coverage.

The Process of We have added to this chapter an appendix containing an extensive spreadPortfolio Management sheet model for sophisticated financial planning. The spreadsheets (available
(Chapter 26) as well at the course website) allow students to study the interaction of taxes

and inflation on long-term financial strategies.

ORGANIZATION AND CONTENT
The text is composed of seven sections that are fairly independent and may be studied in a
variety of sequences. Since there is enough material in the book for a two-semester course,
clearly a one-semester course will require the instructor to decide which parts to include.
Part I is introductory and contains important institutional material focusing on the financial environment. We discuss the major players in the financial markets, provide an
overview of the types of securities traded in those markets, and explain how and where securities are traded. We also discuss in depth mutual funds and other investment companies,
which have become an increasingly important means of investing for individual investors.
The material presented in Part I should make it possible for instructors to assign term
projects early in the course. These projects might require the student to analyze in detail a
particular group of securities. Many instructors like to involve their students in some sort
of investment game and the material in these chapters will facilitate this process.
Parts II and III contain the core of modern portfolio theory. Chapter 5 is a general discussion of risk and return, making the general point that historical returns on broad asset
classes are consistent with a risk–return trade-off. We focus more closely in Chapter 6 on
how to describe investors’ risk preferences. In Chapter 7 we progress to asset allocation and
then in Chapter 8 to portfolio optimization.
After our treatment of modern portfolio theory in Part II, we investigate in Part III the
implications of that theory for the equilibrium structure of expected rates of return on risky
assets. Chapters 9 and 10 treat the capital asset pricing model and its implementation using
index models, and Chapter 11 covers multifactor descriptions of risk and the arbitrage pricing theory. We complete Part II with a chapter on the efficient markets hypothesis, including its rationale as well as the behavioral critique of the hypothesis, the evidence for and
against it, and a chapter on empirical evidence concerning security returns. The empirical
evidence chapter in this edition follows the efficient markets chapter so that the student can
use the perspective of efficient market theory to put other studies on returns in context.
Part IV is the first of three parts on security valuation. This Part treats fixed-income securities—bond pricing (Chapter 14), term structure relationships (Chapter 15), and interestrate risk management (Chapter 16). The next two Parts deal with equity securities and
derivative securities. For a course emphasizing security analysis and excluding portfolio
theory, one may proceed directly from Part I to Part III with no loss in continuity.


Bodie−Kane−Marcus:

Investments, Sixth Edition

Front Matter

Preface

© The McGraw−Hill
Companies, 2004

Walkthrough
This book contains several features designed to
make it easy for the student to understand,
absorb, and apply the concepts and
techniques presented.

New and
Enhanced
Pedagogy

Concept Check
A unique feature of this book is the
inclusion of Concept Checks in the body
of the text. These self-test questions and
problems enable the student to determine whether he or she has understood the preceding material. Detailed
solutions are provided at the end of
each chapter.

CONCEPT
CHECK
QUESTION 1

☞

a. Suppose the real interest rate is 3% per year and the expected inflation
rate is 8%. What is the nominal interest rate?
b. Suppose the expected inflation rate rises to 10%, but the real rate is
unchanged. What happens to the nominal interest rate?

Bills and Inflation, The Fisher equation predicts a close connection between inflation and the
1963–2002 rate of return on T-bills. This is apparent in Figure 5.2, which plots both time
series on the same set of axes. Both series tend to move together, which is
consistent with our previous statement that expected inflation is a significant force determining the nominal rate of interest.
For a holding period of 30 days, the difference between actual and expected inflation is
not large. The 30-day bill rate will adjust rapidly to changes in expected inflation induced
by observed changes in actual inflation. It is not surprising that we see nominal rates on
bills move roughly in tandem with inflation over time.

SOLUTIONS
TO CONCEPT
CHECKS

$2,885.9 Ϫ $2.3
ϭ $7.79
370.4
2. The net investment in the Class A shares after the 4% commission is $9,600. If the
fund earns a 10% return, the investment will grow after n years to $9,600 ϫ (1.10)n.
The Class B shares have no front-end load. However, the net return to the investor
after 12b-1 fees will be only 9.5%. In addition, there is a back-end load that reduces
1. NAV ϭ

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Bodie−Kane−Marcus:
Investments, Sixth Edition

Front Matter

© The McGraw−Hill
Companies, 2004

Preface

Current Event Boxes
Short articles from business periodicals are
included in boxes throughout the text. The

articles are chosen for relevance, clarity of
presentation, and consistency with good sense.

SPUN GOLD
DID WALL STREET FIRMS BRIBE BOSSES WITH SHARES?
Back in 1997, reports that Robertson Stephens, a Silicon
Valley investment bank, was “spinning” IPO shares to executives who rewarded them with banking mandates
prompted an SEC probe into the practice. The probe was
soon abandoned. The practice boomed, becoming one of
the more lucrative ways in which executives combined with
Wall Street to abuse ordinary shareholders.

On August 30th Citigroup told congressional investigators that in 1997–2000 it had allocated IPO shares to Bernie
Ebbers that had generated profits of $11m for the former
boss of WorldCom, a telecoms firm which was a big Citigroup client, and is now bust thanks to fraud. Other WorldCom executives had also benefited. Citi claims that these

investment-banking business in return. Its “host of benign”
explanations for why some shares were allocated retrospectively, giving executives a risk-free gain, seems thin. So
does its claim that Jack Grubman, until last month the
bank’s top telecoms analyst, played no part in allocating
shares to executives. Among the documents that Citigroup
sent to Congress was a memo copied to Mr. Grubman that
listed executives at several telecoms firms who had expressed interest in shares in IPOs.
Regulators and the courts will have to decide whether
allocations of shares to executives were, in effect, bribes. If
so, the punishment could be severe. Nor is Citi the only firm
at risk. Credit Suisse First Boston gave shares in IPOs

Excel Applications
The Sixth Edition has expanded the boxes
featuring Excel Spreadsheet Applications.
A sample spreadsheet is presented in the

E

X

C

E

L

A

P

P

L

I

text with an interactive version and related
questions available on the book website
at www.mhhe.com/bkm.

C

A

T

I

O

N

S

SHORT SALE

This Excel spreadsheet model was built using the text example for DotBomb. The model allows
you to analyze the effects of returns, margin calls, and different levels of initial and maintenance
margins. The model also includes a sensitivity analysis for ending stock price and return on
investment.
You can learn more about this spreadsheet model using the interactive version available at our
Online Learning Center at www.mhhe.com/bkm.

A
1
2
3
4
5
6
7
8
9
10

Initial Investment
Initial Stock Price
Number of Shares Sold Short
Ending Stock Price
Cash Dividends Per Share
Initial Margin Percentage
Maintenance Margin Percentage

B

$50,000.00

$100.00
1,000
$70.00
$0.00
50.00%
30.00%

C
Action or Formula
for Column B
Enter data
Enter data
(B4/B9)/B5
Enter data
Enter data
Enter data
Enter data

D
Ending
St Price
$170.00
160.00
150.00
140.00
130.00
120.00

E
Return on

Investment
58.33%
-133.33%
-116.67%
-100.00%
-83.33%
-66.67%
-50.00%


Bodie−Kane−Marcus:
Investments, Sixth Edition

Front Matter

Summary and End-of-Chapter Problems
At the end of each chapter, a detailed
Summary outlines the most important
concepts presented. The problems that
follow the Summary progress from simple

Preface

© The McGraw−Hill
Companies, 2004

to challenging and many are taken from
CFA examinations. These represent the kinds
of questions that professionals in the field
believe are relevant to the “real world” and

are indicated by an icon in the text margin.

SUMMARY

1. Speculation is the undertaking of a risky investment for its risk premium. The risk premium has to be large enough to compensate a risk-averse investor for the risk of the
investment.
2. A fair game is a risky prospect that has a zero-risk premium. It will not be undertaken
by a risk-averse investor.
3. Investors’ preferences toward the expected return and volatility of a portfolio may be
expressed by a utility function that is higher for higher expected returns and lower
for higher portfolio variances. More risk-averse investors will apply greater penalties for
risk. We can describe these preferences graphically using indifference curves.

PROBLEMS

1. Suppose you discover a treasure chest of $10 billion in cash.
a. Is this a real or financial asset?
b. Is society any richer for the discovery?
c. Are you wealthier?
d. Can you reconcile your answers to (b) and (c)? Is anyone worse off as a result of
the discovery?
2. Lanni Products is a start-up computer software development firm. It currently owns
computer equipment worth $30,000 and has cash on hand of $20,000 contributed
by Lanni’s owners. For each of the following transactions, identify the real and/or
fnancial assets that trade hands. Are any financial assets created or destroyed in the
transaction?

2. A municipal bond carries a coupon of 63⁄4% and is trading at par; to a taxpayer in a
34% tax bracket, this bond would provide a taxable equivalent yield of:
a. 4.5%

b. 10.2%
c. 13.4%
d. 19.9%
3. Which is the most risky transaction to undertake in the stock index option markets if the stock market is expected to increase substantially after the transaction is
completed?
a. Write a call option.
b. Write a put option

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Bodie−Kane−Marcus:
Investments, Sixth Edition

Front Matter

Websites
Another feature in this edition is the
inclusion of website addresses. The sites have

WEBSITES

© The McGraw−Hill
Companies, 2004

Preface

been chosen for relevance to the chapter and

for accuracy so students can easily research
and retrieve financial data and information.

www.executivelibrary.com
This site gives access to instant financial and market news from around the world.
ceoexpress.com/default.asp
This site provides a comprehensive list of links for business and financial managers.

Internet Exercises: E-Investments
These exercises provide students with a
structured set of steps to finding financial
data on the Internet. Easy-to-follow

E-INVESTMENTS

Choosing a
Mutual Fund

instructions and questions are presented
so students can utilize what they’ve learned
in class in today’s Web-driven world.

Here are the websites for three of the largest mutual fund companies:
Fidelity Investments: www.fidelity.com
Putnam Investments: www.putnaminv.com
Vanguard Group: www.vanguard.com
Pick three or four funds from one of these sites. What are the investment objectives of each
fund? Find the expense ratio of each fund. Which fund has had the best recent performance?
What are the major holdings of each fund?

Internet Exercises:
Standard & Poor’s Problems
New to this edition! Relevant chapters
contain problems directly incorporating

the Educational Version of Market Insight,
a service based on Standard & Poor’s
renowned COMPUSTAT® database. Problems
are based on real market data to gain a better
understanding of practical business situations.

Go to www.mhhe.com/business/finance/edumarketinsight. Select a company from
the Population and from the Company Research Page, link to the EDGAR materials
from the menu at the left of the page. What SEC reports are required of public companies? (Check the Archives for prior reports filed by your company.) Briefly explain the
role of each in achieving the mission of the SEC.


Bodie−Kane−Marcus:
Investments, Sixth Edition

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Front Matter

Preface

© The McGraw−Hill
Companies, 2004

PREFACE

Part V is devoted to equity securities. We proceed in a “top down” manner, starting with
the broad macroeconomic environment (Chapter 17), next moving on to equity valuation
(Chapter 18), and then using this analytical framework, we treat fundamental analysis including financial statement analysis (Chapter 19).
Part VI covers derivative assets such as options, futures, swaps, and callable and convertible securities. It contains two chapters on options and two on futures. This material
covers both pricing and risk management applications of derivatives.
Finally, Part VII presents extensions of previous material. Topics covered in this Part
include evaluation of portfolio performance (Chapter 24), portfolio management in an international setting (Chapter 25), a general framework for the implementation of investment
strategy in a nontechnical manner modeled after the approach presented in CFA study materials (Chapter 26), and an overview of active portfolio management (Chapter 27).

SUPPLEMENTS
For the Instructor Instructor’s Resource CD 0072861819 This comprehensive CD
contains all the following instructor supplements. We have compiled them in
electronic format for easier access and convenience. Print copies are available through your
publisher’s representative.
• Instructor’s Manual The Instructor’s Manual, prepared by Richard D. Johnson,
Colorado State University, has been revised and improved in this edition. Each
chapter includes a chapter overview, a review of learning objectives, an annotated
chapter outline (organized to include the Transparency Masters/PowerPoint
package), and teaching tips and insights. Transparency Masters are located at the
end of each chapter.
• PowerPoint Presentation Software These presentation slides, also developed
by Richard D. Johnson, provide the instructor with an electronic format of the
Transparency Masters. These slides, revised for this edition, follow the order of
the chapters, but if you have PowerPoint software, you may choose to customize
the presentations to fit your own lectures.
• Test Bank The Test Bank, prepared by Larry Prather, East Tennessee State
University, has been revised to increase the quantity and variety of questions. Shortanswer essay questions are also provided for each chapter to further test student
comprehension and critical thinking abilities. The Test Bank is also available in
computerized format for Windows.

The Wall Street Journal Edition Your students can subscribe to The Wall Street
Journal for 15 weeks (which includes access to the Dow Jones Interactive Online Asset) at
a specially priced rate of $20.00 in addition to the price of the text. Students will receive a
“How to Use the WSJ” handbook plus a pass code card shrink-wrapped with the text.
Videos 0072861835 There are seven video segments covering careers, financial markets, bonds, going public, derivatives, portfolio management, and foreign exchange.

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Investments, Sixth Edition

Front Matter

PREFACE

Preface

© The McGraw−Hill
Companies, 2004

xxvii

For the Student Solutions Manual 007286186X The Solutions Manual, prepared by
Bruce Swensen, Adelphi University, provides detailed solutions to the endof-chapter problems. This manual is available for packing with the text. Please contact your
local McGraw-Hill/Irwin representative for further details on how to order the Solutions
Manual/Textbook package.
Student Problem Manual 0072861843 New to this edition! To give students a

better resource for working through problems, we have created a comprehensive problem
manual. This useful supplement, also developed by Larry Prather, contains problems created to specifically relate to the concepts discussed in each chapter. Solutions are provided
at the end of each chapter.
Online Learning Center Find a wealth of information online! At www.mhhe.com/
bkm, instructors will have access to teaching support such as electronic files for the ancillary material and students will have access to study materials created specifically for this
text. The Excel Applications spreadsheets, also prepared by Bruce Swensen, are located at
this site. Additional information on the text and authors and links to our powerful support
materials are also available.
Standard & Poor’s Educational Version of Market Insight McGraw-Hill/
Irwin and the Institutional Market Services division of Standard & Poor’s are pleased to
announce an exclusive partnership that offers instructors and students access to the educational version of Standard & Poor’s Market Insight. The Educational Version of Market
Insight is a rich online resource that provides 6 years of fundamental financial data for
over 500 companies in the renowned COMPUSTAT® database. Standard and Poor’s and
McGraw-Hill/Irwin have selected the best, most-often researched companies in the database. S&P-specific problems can be found at the end of relevant chapters in this text.
PowerWeb With PowerWeb, getting information online has never been easier. This
McGraw-Hill/Irwin website is a reservoir of course-specific articles and current events.
Simply type in a discipline-specific topic for instant access to articles, essays, and news for
your class.
All of the articles have been recommended to PowerWeb by professors, which means
you will not get all the clutter that seems to pop up with typical search engines. However,
PowerWeb is much more than a search engine. Students can visit PowerWeb to take a selfgrading quiz, work through interactive exercises, click through an interactive glossary, and
even check the daily news. In fact, an expert for each discipline analyzes the day’s news to
show students how it is relevant to their field of study.


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Investments, Sixth Edition

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Front Matter

Preface

© The McGraw−Hill
Companies, 2004

PREFACE

Investments Online Introducing Investments Online! For each of the 18 different
topics, the student completes challenging exercises and discussion questions that draw on
recent articles, company reports, government data, and other Web-based resources. The
“Finance Tutor Series” provides questions and problems that not only assess and improve
students’ understanding of the subject but also help students to apply it in real-world
contexts.

ACKNOWLEDGMENTS
Throughout the development of this text, experienced instructors have provided critical
feedback and suggestions for improvement. These individuals deserve a special thanks for
their valuable insights and contributions. The following instructors played a vital role in the
development of this and previous editions of Investments:
Scott Besley
University of Florida
John Binder
University of Illinois at Chicago
Paul Bolster
Northeastern University
Phillip Braun
Northwestern University
L. Michael Couvillion

Plymouth State University
Anna Craig
Emory University
David C. Distad
University of California at Berkeley
Craig Dunbar
University of Western Ontario

Michael C. Ehrhardt
University of Tennessee at Knoxville
David Ellis
Babson College
Greg Filbeck
University of Toledo
Jeremy Goh
Washington University
Richard Grayson
Loyola College
John M. Griffin
Arizona State University
Mahmoud Haddad
Wayne State University
Robert G. Hansen
Dartmouth College

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Bodie−Kane−Marcus:
Investments, Sixth Edition

Front Matter

Preface

PREFACE

Joel Hasbrouck
New York University
Andrea Heuson
University of Miami
Eric Higgins
Drexel University
Shalom J. Hochman
University of Houston
Eric Hughson
University of Colorado
A. James Ifflander
A. James Ifflander and Associates
Robert Jennings
Indiana University
Richard D. Johnson
Colorado State University
Susan D. Jordan
University of Kentucky
G. Andrew Karolyi
Ohio State University
Josef Lakonishok

University of Illinois at Champaign/Urbana
Malek Lashgari
University of Hartford
Dennis Lasser
Binghamton University
Larry Lockwood
Texas Christian University
Christopher K. Ma
Texas Tech University
Anil K. Makhija
University of Pittsburgh
Steven Mann
University of South Carolina
Deryl W. Martin
Tennessee Technical University
Jean Masson
University of Ottawa
Ronald May
St. John’s University
Rick Meyer
University of South Florida
Mbodja Mougoue
Wayne State University
Gurupdesh Pandner
DePaul University
Don B. Panton
University of Texas at Arlington

© The McGraw−Hill
Companies, 2004

xxix
Dilip Patro
Rutgers University
Robert Pavlik
Southwest Texas State
Herbert Quigley
University of D.C.
Speima Rao
University of Southwestern Louisiana
Leonard Rosenthal
Bentley College
Eileen St. Pierre
University of Northern Colorado
Anthony Sanders
Ohio State University
Don Seeley
University of Arizona
John Settle
Portland State University
Edward C. Sims
Western Illinois University
Robert Skena
Carnegie Mellon University
Steve L. Slezak
University of North Carolina at Chapel Hill
Keith V. Smith
Purdue University
Patricia B. Smith
University of New Hampshire

Laura T. Starks
University of Texas
Manuel Tarrazo
University of San Francisco
Steve Thorley
Brigham Young University
Jack Treynor
Treynor Capital Management
Charles A. Trzincka
SUNY Buffalo
Yiuman Tse
Suny Binghampton
Gopala Vasuderan
Suffolk University
Joseph Vu
De Paul University
Simon Wheatley
University of Chicago
Marilyn K. Wiley
Florida Atlantic University


Bodie−Kane−Marcus:
Investments, Sixth Edition

xxx

Front Matter

Preface

© The McGraw−Hill
Companies, 2004

PREFACE

James Williams
California State University at Northridge
Tony R. Wingler
University of North Carolina at Greensboro
Guojun Wu
University of Michigan

Hsiu-Kwang Wu
University of Alabama
Thomas J. Zwirlein
University of Colorado at Colorado Springs

For granting us permission to include many of their examination questions in the text, we
are grateful to the Institute of Chartered Financial Analysts.
Much credit is due also to the development and production team: our special thanks
go to Steve Patterson, Executive Editor/Publisher; Rhonda Seelinger, Senior Marketing
Manager; Meg Beamer, Marketing Specialist; Christina Kouvelis and Denise McGuinness,
Developmental Editors; Jean Lou Hess, Senior Project Manager; Keith McPherson, Director of Design; Michael McCormick, Production Supervisor; Cathy Tepper, Supplements
Coordinator; and Kai Chiang, Media Technology Lead Producer.
Finally, we thank Judy, Hava, and Sheryl, who contributed to the book with their
support and understanding.
Zvi Bodie
Alex Kane
Alan J. Marcus

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Bodie−Kane−Marcus:
Investments, Sixth Edition

I. Introduction

© The McGraw−Hill
Companies, 2004

2. Financial Instruments

C

H

A

P

T

E

R

T

W

O

FINANCIAL INSTRUMENTS
This chapter covers a range of financial securities and the markets in which
they trade. Our goal is to introduce you to the features of various security
types. This foundation will be necessary to understand the more analytic
material that follows in later chapters. Financial markets are traditionally
segmented into money markets and capital markets. Money market
instruments include short-term, marketable, liquid, low-risk debt securities.
Money market instruments sometimes are called cash equivalents, or just
cash for short. Capital markets, in contrast, include longer-term and riskier
securities. Securities in the
capital market are much more
diverse than those found
within the money market. For
this reason, we will subdivide
the capital market into four
segments: longer-term bond
markets, equity markets, and
the derivative markets for
options and futures. We first
describe money market
instruments. We then move on
to debt and equity securities.
We explain the structure of
various stock market indexes

in this chapter because market
benchmark portfolios play an important role in portfolio construction and
evaluation. Finally, we survey the derivative security markets for options
and futures contracts.

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I. Introduction

2. Financial Instruments

© The McGraw−Hill
Companies, 2004

PART I Introduction

Figure 2.1
Rates on money
market securities

Source: The Wall Street Journal, January 6, 2003. Reprinted by permission of The Wall Street Journal, © 2003 Dow Jones & Company,
Inc. All Rights Reserved Worldwide.

2.1

THE MONEY MARKET
The money market is a subsector of the fixed-income market. It consists of very short-term
debt securities that usually are highly marketable. Many of these securities trade in large
denominations, and so are out of the reach of individual investors. Money market funds,
however, are easily accessible to small investors. These mutual funds pool the resources of
many investors and purchase a wide variety of money market securities on their behalf.
Figure 2.1 is a reprint of a money rates listing from The Wall Street Journal. It includes
the various instruments of the money market that we will describe in detail. Table 2.1 lists
outstanding volume in 2002 of the major instruments of the money market.

Treasury Bills U.S. Treasury bills (T-bills, or just bills, for short) are the most marketable
of all money market instruments. T-bills represent the simplest form of borrowing: The government raises money by selling bills to the public. Investors buy the bills
at a discount from the stated maturity value. At the bill’s maturity, the holder receives from
the government a payment equal to the face value of the bill. The difference between the
purchase price and ultimate maturity value constitutes the investor’s earnings.
T-bills are issued with initial maturities of 28, 91, or 182 days. Individuals can purchase
T-bills directly, at auction, or on the secondary market from a government securities dealer.
T-bills are highly liquid; that is, they are easily converted to cash and sold at low transaction cost and with not much price risk. Unlike most other money market instruments,

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I. Introduction

2. Financial Instruments

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33

CHAPTER 2 Financial Instruments

Table 2.1

Major Components of the Money Market (December 2002)
$ Billion
Repurchase agreements
Small-denomination time deposits*
Large-denomination time deposits
Eurodollars
Treasury bills
Commercial paper
Savings deposits
Money market mutual funds

$ 376.6
970.1
793.3
225.2
811.2
1,320.6
2,304.5
2,179.3

*Small denominations are less than $100,000.
Sources: Economic Report of the President, U.S. Government Printing Office, 2002; Flow of Funds Accounts: Flows & Outstandings,
Board of Governors of the Federal Reserve System, September 2002.

which sell in minimum denominations of $100,000, T-bills sell in minimum denominations
of only $10,000. The income earned on T-bills is exempt from all state and local taxes,
another characteristic distinguishing bills from other money market instruments.

Certificates of Deposit A certificate of deposit, or CD, is a time deposit with a bank. Time deposits
may not be withdrawn on demand. The bank pays interest and principal to
the depositor only at the end of the fixed term of the CD. CDs issued in denominations
greater than $100,000 are usually negotiable, however; that is, they can be sold to another
investor if the owner needs to cash in the certificate before its maturity date. Short-term
CDs are highly marketable, although the market significantly thins out for maturities of
3 months or more. CDs are treated as bank deposits by the Federal Deposit Insurance Corporation, so they are insured for up to $100,000 in the event of a bank insolvency.

Commercial Paper Large, well-known companies often issue their own short-term unsecured
debt notes rather than borrow directly from banks. These notes are called
commercial paper. Very often, commercial paper is backed by a bank line of credit, which
gives the borrower access to cash that can be used (if needed) to pay off the paper at
maturity.
Commercial paper maturities range up to 270 days; longer maturities would require registration with the Securities and Exchange Commission and so are almost never issued.
Most often, commercial paper is issued with maturities of less than 1 or 2 months. Usually,
it is issued in multiples of $100,000. Therefore, small investors can invest in commercial
paper only indirectly, via money market mutual funds.
Commercial paper is considered to be a fairly safe asset, because a firm’s condition presumably can be monitored and predicted over a term as short as 1 month. Many firms issue
commercial paper intending to roll it over at maturity, that is, issue new paper to obtain the
funds necessary to retire the old paper.

Bankers’ Acceptances A banker’s acceptance starts as an order to a bank by a bank’s customer to
pay a sum of money at a future date, typically within 6 months. At this stage,
it is similar to a postdated check. When the bank endorses the order for payment as
“accepted,” it assumes responsibility for ultimate payment to the holder of the acceptance.
At this point, the acceptance may be traded in secondary markets like any other claim on


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2. Financial Instruments

© The McGraw−Hill
Companies, 2004

PART I Introduction

the bank. Bankers’ acceptances are considered very safe assets because traders can substitute the bank’s credit standing for their own. They are used widely in foreign trade where
the creditworthiness of one trader is unknown to the trading partner. Acceptances sell at
a discount from the face value of the payment order, just as T-bills sell at a discount from
par value.

Eurodollars Eurodollars are dollar-denominated deposits at foreign banks or foreign
branches of American banks. By locating outside the United States, these
banks escape regulation by the Federal Reserve Board. Despite the tag “Euro,” these
accounts need not be in European banks, although that is where the practice of accepting

dollar-denominated deposits outside the United States began.
Most Eurodollar deposits are for large sums, and most are time deposits of less than
6 months’ maturity. A variation on the Eurodollar time deposit is the Eurodollar certificate
of deposit. A Eurodollar CD resembles a domestic bank CD except that it is the liability of
a non-U.S. branch of a bank, typically a London branch. The advantage of Eurodollar CDs
over Eurodollar time deposits is that the holder can sell the asset to realize its cash value
before maturity. Eurodollar CDs are considered less liquid and riskier than domestic CDs,
however, and thus offer higher yields. Firms also issue Eurodollar bonds, which are dollardenominated bonds outside the U.S., although bonds are not a money market investment
because of their long maturities.

Repos and Reverses Dealers in government securities use repurchase agreements, also called
“repos” or “RPs,” as a form of short-term, usually overnight, borrowing. The
dealer sells government securities to an investor on an overnight basis, with an agreement
to buy back those securities the next day at a slightly higher price. The increase in the price
is the overnight interest. The dealer thus takes out a 1-day loan from the investor, and the
securities serve as collateral.
A term repo is essentially an identical transaction, except that the term of the implicit
loan can be 30 days or more. Repos are considered very safe in terms of credit risk because
the loans are backed by the government securities. A reverse repo is the mirror image of a
repo. Here, the dealer finds an investor holding government securities and buys them,
agreeing to sell them back at a specified higher price on a future date.

Federal Funds Just as most of us maintain deposits at banks, banks maintain deposits of
their own at a Federal Reserve bank. Each member bank of the Federal Reserve System, or “the Fed,” is required to maintain a minimum balance in a reserve account
with the Fed. The required balance depends on the total deposits of the bank’s customers.
Funds in the bank’s reserve account are called federal funds, or fed funds. At any time,
some banks have more funds than required at the Fed. Other banks, primarily big banks in
New York and other financial centers, tend to have a shortage of federal funds. In the federal funds market, banks with excess funds lend to those with a shortage. These loans,
which are usually overnight transactions, are arranged at a rate of interest called the federal
funds rate.

Although the fed funds market arose primarily as a way for banks to transfer balances
to meet reserve requirements, today the market has evolved to the point that many large
banks use federal funds in a straightforward way as one component of their total sources of
funding. Therefore, the fed funds rate is simply the rate of interest on very short-term loans
among financial institutions.

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I. Introduction

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2. Financial Instruments

35

CHAPTER 2 Financial Instruments

Brokers’ Calls Individuals who buy stocks on margin borrow part of the funds to pay for
the stocks from their broker. The broker in turn may borrow the funds from
a bank, agreeing to repay the bank immediately (on call) if the bank requests it. The rate
paid on such loans is usually about 1% higher than the rate on short-term T-bills.

The LIBOR Market The London Interbank Offered Rate (LIBOR) is the rate at which large
banks in London are willing to lend money among themselves. This rate,

which is quoted on dollar-denominated loans, has become the premier short-term interest
rate quoted in the European money market, and it serves as a reference rate for a wide
range of transactions. For example, a corporation might borrow at a floating rate equal to
LIBOR plus 2%.

Yields on Money Although most money market securities are of low risk, they are not riskMarket Instruments free. For example, the commercial paper market was rocked in 1970 by the
Penn Central bankruptcy, which precipitated a default on $82 million of
commercial paper. Money market investors became more sensitive to creditworthiness
after this episode, and the yield spread between low- and high-quality paper widened.
The securities of the money market do promise yields greater than those on default-free
T-bills, at least in part because of greater relative riskiness. In addition, many investors require more liquidity; thus they will accept lower yields on securities such as T-bills that can
be quickly and cheaply sold for cash. Figure 2.2 shows that bank CDs, for example, consistently have paid a risk premium over T-bills. Moreover, that risk premium increased with
economic crises such as the energy price shocks associated with the two OPEC disturbances, the failure of Penn Square bank, the stock market crash in 1987, or the collapse of
Long Term Capital Management in 1998.

2.2

THE BOND MARKET
The bond market is composed of longer-term borrowing or debt instruments than those that
trade in the money market. This market includes Treasury notes and bonds, corporate
bonds, municipal bonds, mortgage securities, and federal agency debt.
These instruments are sometimes said to comprise the fixed-income capital market, because most of them promise either a fixed stream of income or a stream of income that is

Figure 2.2 The spread between 3-month CD and Treasury bill rates

Percentage points

18

5

4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
1970

OPEC I

OPEC II

Penn
Square
Market
Crash
LTCM

1975

1980

1985

1990

1995

2000


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I. Introduction

2. Financial Instruments

© The McGraw−Hill
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PART I Introduction

determined according to a specific formula. In practice, these formulas can result in a flow
of income that is far from fixed. Therefore, the term “fixed income” is probably not fully
appropriate. It is simpler and more straightforward to call these securities either debt instruments or bonds.

Treasury Notes The U.S. government borrows funds in large part by selling Treasury notes
and Bonds and Treasury bonds. T-note maturities range up to 10 years, whereas bonds
are issued with maturities ranging from 10 to 30 years. Both are issued in denominations of $1,000 or more. The Treasury announced in late 2001 that it would no
longer issue bonds with maturities beyond 10 years. So, all the bonds it now issues would
more properly be called notes. Nevertheless, investors still commonly call them Treasury
or T-bonds. Both notes and bonds make semiannual interest payments called coupon payments, a name derived from precomputer days, when investors would literally clip coupons
attached to the bond and present a coupon to receive the interest payment. Aside from their

differing maturities at issuance, the only major distinction between T-notes and T-bonds is
that T-bonds may be callable during a given period, usually the last 5 years of the bond’s
life. The call provision gives the Treasury the right to repurchase the bond at par value.
However, the Treasury hasn’t issued callable bonds since 1984.
Figure 2.3 is an excerpt from a listing of Treasury issues in The Wall Street Journal. Notice the highlighted note that matures in November 2008. The coupon income, or interest,
paid by the note is 43⁄4% of par value, meaning that a $1,000 face-value note pays $47.50
in annual interest in two semiannual installments of $23.75 each. The numbers to the right
of the colon in the bid and asked prices represent units of 1⁄32 of a point.
The bid price of the note is 10725⁄32, or 107.7813. The asked price is 10726⁄32, or
107.8125. Although notes and bonds are sold in denominations of $1,000 par value, the
prices are quoted as a percentage of par value. Thus the bid price of 107.7813 should be
interpreted as 107.7813% of par, or $1,077.813, for the $1,000 par value security. Similarly, the note could be bought from a dealer for $1,078.125. The ϩ1 change means the
closing price on this day rose 1⁄32 (as a percentage of par value) from the previous day’s
closing price. Finally, the yield to maturity on the note based on the asked price is 3.27%.
The yield to maturity reported in the financial pages is calculated by determining
the semiannual yield and then doubling it, rather than compounding it for two half-year
periods. This use of a simple interest technique to annualize means that the yield is quoted
on an annual percentage rate (APR) basis rather than as an effective annual yield. The APR
method in this context is also called the bond equivalent yield. We discuss the yield to maturity in more detail in Part 4.
CONCEPT
CHECK
QUESTION 1

☞

What were the bid price, asked price, and yield to maturity of the 6% August
2009 Treasury note displayed in Figure 2.3? What was its asked price the previous day?

Federal Agency Debt Some government agencies issue their own securities to finance their activities. These agencies usually are formed to channel credit to a particular sector of the economy that Congress believes might not receive adequate credit through
normal private sources. Figure 2.4 reproduces listings of some of these securities from The

Wall Street Journal.
The major mortgage-related agencies are the Federal Home Loan Bank (FHLB), the
Federal National Mortgage Association (FNMA, or Fannie Mae), the Government National
Mortgage Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage

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CHAPTER 2 Financial Instruments

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37

Figure 2.3
Treasury bonds
and notes

Source: The Wall Street Journal, January 6, 2003. Reprinted by permission of The Wall
Street Journal, © 2003 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Corporation (FHLMC, or Freddie Mac). The FHLB borrows money by issuing securities
and lends this money to savings and loan institutions to be lent in turn to individuals borrowing for home mortgages.
Freddie Mac and Ginnie Mae were organized to provide liquidity to the mortgage market. Until the pass-through securities sponsored by these agencies were established (see the
discussion of mortgages and mortgage-backed securities later in this section), the lack of a
secondary market in mortgages hampered the flow of investment funds into mortgages and
made mortgage markets dependent on local, rather than national, credit availability.
Some of these agencies are government owned, and therefore can be viewed as branches
of the U.S. government. Thus their debt is fully free of default risk. Ginnie Mae is an
example of a government-owned agency. Other agencies, such as the farm credit agencies, the Federal Home Loan Bank, Fannie Mae, and Freddie Mac, are merely federally
sponsored.
Although the debt of federally sponsored agencies is not explicitly insured by the federal government, it is widely assumed that the government would step in with assistance if


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I. Introduction

2. Financial Instruments

© The McGraw−Hill
Companies, 2004

PART I Introduction

Figure 2.4
Government

agency issues

Source: The Wall Street Journal, January 6, 2003. Reprinted by permission of The Wall Street Journal, 2003 Dow Jones &
Company, Inc. All Rights Reserved Worldwide.

an agency neared default. Thus these securities are considered extremely safe assets, and
their yield spread above Treasury securities is usually small.

CONCEPT
CHECK
QUESTION 2

☞

Using Figure 2.3 and 2.4, compare the yields to maturity of some agency bonds
with that of a Treasury bond of the same maturity date.

International Bonds Many firms borrow abroad and many investors buy bonds from foreign issuers. In addition to national capital markets, there is a thriving international
capital market, largely centered in London.
A Eurobond is a bond denominated in a currency other than that of the country in which
it is issued. For example, a dollar-denominated bond sold in Britain would be called a
Eurodollar bond. Similarly, investors might speak of Euroyen bonds, yen-denominated
bonds sold outside Japan. Since the new European currency is called the euro, the term
Eurobond may be confusing. It is best to think of them simply as international bonds.
In contrast to bonds that are issued in foreign currencies, many firms issue bonds in foreign countries but in the currency of the investor. For example, a Yankee bond is a dollardenominated bond sold in the United States by a non-U.S. issuer. Similarly, Samurai bonds
are yen-denominated bonds sold in Japan by non-Japanese issuers.

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